Economics - Chapter 12-15 Notes.docx

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School

McMaster University

Department

Economics

Course

ECON 1BB3

Professor

Bridget O' Shaughnessy

Semester

Winter

Description

CHAPTER TWELVE – OPEN-ECONOMY MACROECONOMICS: BASIC
CONCEPTS
The International Flow of Goods and Capital
 Closed economy: does not interact with other economies in the world
 Open economy: interacts freely with other economies around the world
 Open economy interacts with other economies in two ways:
o Buys and sells goods/services in world product markets
o Buys and sells stocks/bonds in world financial markets
The Flow of Goods: Exports, Imports and Net Exports
 Exports: goods/services produced domestically and sold abroad
 Imports: goods/services produced abroad and sold domestically
 Net exports: value of nation’s exports minus value of its imports (trade
balance)
 Trade surplus: excess of exports over imports
 Trade deficit: excess of exports over imports
 Balanced trade: exports equal imports
 Factors that might influence country’s exports, imports, net exports:
o Tastes of consumers for domestic/foreign goods
o Prices of goods at home and abroad
o Exchange rates at which people can use domestic currencies to buy
foreign currencies
o Incomes of consumers at home and abroad
o Cost of transporting goods from country to country
o Government policies toward international trade
The Flow of Financial Resources: Net Capital Outflow
 Net capital outflow = (Purchase of foreign assets by domestic residents) –
(Purchase of domestic assets by foreign residents)
 Foreign direct investment: Canadian owner actively manages investment (ex.
Tim Horton’s opens fast-food outlet in Russia)
 Foreign portfolio investment: Canadian owner has more passive role (ex.
Canadian buy stock in Russian corporation)
 Both increase Canadian net capital outflow
 Capital inflow: when net capital outflow is negative
 Influencers of net capital outflow:
o Real interest rates being paid on foreign assets
o Real interest rates being paid on domestic assets
o Perceived economic and political risks of holding assets abroad
o Government policies that affect foreign ownership of domestic assets
The Equality of Net Exports and Net Capital Outflow
 Net exports measures imbalance between exports and imports  Net capital outflow measures imbalance between amount of foreign assets
bought by domestic residents and amount of domestic assets bought by
foreigners
 Net capital outflow must always equal net exports: NCO = NX
 Every international transaction is an exchange
o Seller country transfers good/service to buyer country
o Buyer country gives up asset to pay for it
o Value of asset equals value of good/service sold
 NX > 0 means NCO > 0
 NX < 0 means NCO < 0
Saving, Investment and Their Relationship to the International Flows
 Y = C + I + G + NX
 S = Y – C – G
 S = I + NX
 S = I + NCO
 Saving = Domestic investment + Net capital outflow
 Closed economy: NCO = 0
 Open economy: two uses for saving (domestic investment and NCO)
 When S > I then NCO > 0: nation using some of saving to buy assets abroad
 When S < I then NCO < 0: foreigners financing some of investment by
purchasing domestic assets
Summing Up
Trade Deficit Balanced Trade Trade Surplus
Exports < Imports Exports = Imports Exports > Imports
Net exports < 0 Net exports = 0 Net exports > 0
Y < C + I + G Y = C + I + G Y > C + I + G
Investment < Saving Saving = Investment Saving > Investment
Net capital outflow < 0 Net capital outflow = 0 Net capital outflow > 0
The Prices for International Transactions: Real and Nominal Exchange Rates
Nominal Exchange Rates
 Nominal exchange rate: rate at which person can trade currency of one
country for the currency of another
 Appreciation:
o Increase in the value of a currency as measured by the amount of
foreign currency it can buy
o Strengthens dollar
o Can buy more foreign currency
 Depreciation:
o Decrease in value of a currency as measured by amount of foreign
currency it can buy
o Weakens dollar o Can buy less foreign currency
Real Exchange Rates
 Real exchange rate: rate at which person can trade goods/services of one
country for goods/services of another
 Expressed as unit of foreign item per unit of domestic item (ex. half a case of
German beer per Canadian beer)
 Real exchange rate = (nominal exchange rate x domestic price)/foreign price
 Real exchange rate = (e x P)/P*
o “e”: exchange rate
o P: price of Canadian basket
o P*: price of foreign basket
 Fall in Canadian RER:
o Canadian goods cheaper relative to foreign goods
o Consumers buy more Canadian goods
o Increase net exports
 Rise in Canadian RER:
o Canadian goods more expensive relative to foreign goods
o Net exports fall
A First Theory of Exchange-Rate Determination: Purchasing-Power Parity
The Basic Logic of Purchasing-Power Parity
 Purchasing-power parity: unit of any given currency should be able to buy
same quantity of goods in all countries
 Law of one price: good must sell for same price in all locations
 Arbitrage: taking advantage of differences in prices in different markets
 A unit of all currencies must have the same real value in every country
Implications of Purchasing-Power Parity
 Nominal exchange rate between currencies of two countries depends of price
levels in countries
 1 = eP/P* or e = P*/P
 Nominal exchange rates change when price levels change
 When bank prints a lot of money it loses value in terms of goods/services it
can buy and in terms of amount of other currencies it can buy
Limitations of Purchasing-Power Parity
 Not always completely accurate
 Exchange rates do not always move so that dollar has same real value in all
countries all the time
 Two reasons why:
1. Many goods not easily traded (ex. services)
2. Tradable goods are not always perfect substitutes when produced in
different countries
 Causes exchange rate to fluctuate over time Interest Rate Determination in a Small Open Economy with Perfect Capital
Mobility
A Small Open Economy
 Small open economy:
o Trades goods/services with other economies
o Has negligible effect on world prices and interest rates
 Changes in Canadian financial markets have negligible effects on world
interest rates
Perfect Capital Mobility
 Perfect capital mobility: full access to world financial markets
 Canadians have full access to world financial markets
 People in rest of world have full access to Canadian financial markets
 Real interest rate in Canada should equal world’s real interest rate
 r = r
 Interest rate parity: real interest rate on comparable financial assets should
be the same in all economies with full access to world financial markets
Limitations to Interest Rate Parity
 Real interest rate in Canada not always equal to real interest rate in rest of
world
 Two reasons why:
1. Financial assets carry the possibility of default
o Seller ma not repay the buyer
o One seller may be more likely to default than another seller of
a similar asset
o Higher default risk means higher interest rate
2. Financial assets for sale in different countries are not perfect
substitutes (ex. different government tax returns)
CHAPTER THIRTEEN – A MACROECONOMIC THEORY OF THE OPEN
ECONOMY
Supply and Demand for Loanable Funds and for Foreign-Currency Exchange
 Takes GDP as given
 Takes price as given
 Takes real interest rate as given (equal to world interest rate because of
perfect capital mobility)
 Market for loanable funds: coordinates saving, investment, flow of loanable
funds abroad (NCO)
 Market for foreign-currency exchange: coordinates people who want to
exchange domestic currency for currency of other countries The Market for Loanable Funds
 S = I + NCO
 Saving = Domestic investment + Net capital outflow
 Amount a nation saves does not have to equal amount it spends to purchase
domestic capital
 Demand for loanable funds comes from domestic investment
 Supply of loanable funds comes from national saving
 If S > I:
o Leftover amount can be used to buy assets abroad
o NCO is positive
 If S < I:
o Shortfall can be met by savings of foreigners
o NCO is negative
 Quantity of loanable funds demanded and supplied depends on real interest
rate:
o High RER makes people want to save so increases quantity of loanable
funds supplied
o Also makes borrowing more costly so discourages investment and
reduces quantity of loanable funds demanded
The Market for Foreign-Currency Exchange
 People want to trade goods/services, financial assets with people in other
countries
 Want to be paid in own currency
 Must purchase foreign currency before purchasing foreign good
 S – I = NX
 Saving – Domestic investment = Net exports
 Difference between national saving (S) and domestic investment (I) equals
net capital outflow (NCO)
 NCO = NX (quantity of dollars supplied in market to buy foreign assets)
 RER is price that balances supply and demand in market for foreign-currency
exchange
 RER appreciates:
o Canadian goods become more expensive compared to foreign
o Canadian goods less attractive to consumers
o Exports from Canada fall
o Imports into Canada rise
o Net exports fall
o Reduces Q of dollars demanded
 RER depreciates: Canadian goods become less expensive

Equilibrium in the Open Economy
Net Capital Outflow: The Link Between the Two Markets Simultaneous Equilibrium in Two Markets
How Policies and Events Affect an Open Economy
Increase in World Interest Rates
 Small open economy: real interest rate = world interest rate
 Events outside Canada that cause world interest to change have effects on
Canadian economy
 US is largest economy in world
 Changes in US interest rate have large impact on world interest rate
 Increase in world interest rate:
o Market for loanable funds: no curve shifts
o Increase causes a slide up the supply and demand curves
o Quantity of loanable funds made available by saving rises
o Quantity of loanable funds demanded for domestic investment falls
o Market for foreign-currency exchange: increase in NCO causes shit to
the right
o Increase in supply of dollars causes real exchange rate to depreciate
o Dollar become less valuable relative to other currencies
o Canadian goods are less expensive compared with foreign goods
o Exports from Canada rise
o Imports into Canada fall
o Net exports rise
Government Budget Deficits and Surpluses
 Government budget deficit in a closed economy:
o Reduces supply of loanable funds
o Drives up interest rate
o Crowds out investment
 Budget deficit in an open economy:
o Supply curve for loanable funds shifts to the left
o Causes net capital outflow (NCO) to fall
o Supply of Canadian dollars is reduced
o Move supply curve in market for foreign-currency exchange to the left
o Dollar becomes more valuable relative to foreign currency
o Canadian goods more expensive than foreign goods
o Exports fall and imports rise (net exports fall)
Trade Policy
 Trade policy: government policy that directly influences quantity of
goods/services that a country imports/exports
 Tariff: tax on goods produced abroad and sold domestically
 Import quota: limit on quantity of a good that is produced abroad and sold
domestically
 Effects of an import quota:
o Reduces imports at any given real exchange rate o Net exports rise for any given real exchange rate
o Increase in demand for dollars in the market for foreign-currency
exchange (D curve shifts to the right)
o Real exchange rate appreciates
o No change in NCO
o No change in net exports
o Reduces both imports and exports so net exports are unchanged
 Trade policies do not affect the trade balance (do not affect net exports)
 Do not alter national saving or domestic investment
 NX = NCO = S – I
 Real exchange rate adjusts to keep trade balance the same
CHAPTER FOURTEEN – AGGREGATE DEMAND AND AGGREGATE
SUPPLY
Three Key Facts about Economic Fluctuations
 Recession: a period of declining real incom